Ignore The Big Upheaval In The Oil Patch

January 15, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Deborah Frame, vice president of investments at Toronto-based Cougar Global Investments.

 

A prolonged stretch of low oil prices will bring on economic and geopolitical changes that not so long ago were unthinkable, and regardless of short-term changes in demand and supply, the fracking industry is definitely in for something of a blood-letting.

 

After all, the global oil market appears heavily oversupplied for the first half of 2015. Saudi, Canadian, American, Iraqi, Kuwaiti, Russian and UAE production remain at or near their highest-ever levels, according to the International Energy Agency’s December report.

 

But all these surprising facts—and I’ll lay out more below in the spirit of illustrating what is real and salient—may be nothing more than fodder for dramatic headlines. The way we see it at Cougar Global, none of this really changes much in how investors should be allocating assets; namely, funds that canvass broad swaths of the market.

 

That means keeping emphasis, as always, on owning core securities, such as the SPDR S&P 500 ETF (SPY | A-98), among others. But before laying out the various options, let’s take a closer look at the astonishing developments in the world of oil and gas, and to what it all means to various producers.

 

Global Economic Sluggishness

The surge in production comes as growth in global demand hit a five-year low in 2014, due to a sharp slowdown in Chinese oil demand growth and steep contractions in Europe and Japan.

 

Most of the world outside North America is either in or near a recession. China is the second-largest consumer of oil in the world and surpassed the United States as the largest importer of liquid fuels in late 2013.

 

China is expected to burn through 3 million more barrels per day in 2020 compared with 2012, accounting for about one-quarter of global demand growth over that time. Although there is much uncertainty, China just wrapped up a disappointing fourth quarter, capping off its slowest annual growth in more than a quarter century.

 

The point is the trajectory of China's economy will significantly impact oil prices in 2015.

 

And in Europe, where policymakers are struggling with deflation, lower oil prices will only make the European Central Bank’s challenge harder as it loosens monetary policy to try to raise consumer prices. Venezuela, which relies on oil for 95 percent of its export revenue, risks insolvency.

 

The Harsh Reality

We are on the verge of a Brent crude oil price of $40 a barrel, and at this price and below it, producers are likely to shut-in enough output so that there is a significant reduction in global oil supply.

 

If Brent falls to $40—it’s now at $46—1.5 million barrels per day of global production would be losing money. Most of those money-losing operations would be in Canada, followed by the U.S. and then Colombia.  

 

 

Horizontal drilling and hydraulic fracturing in underground shale rock has boosted U.S output by 66 percent in the past five years, but U.S. shale oil production is very sensitive to prices, averaging close to $65 per barrel.

 

Unlike conventional oil production, shale oil operates with shorter lead times and minimal upfront capital outlays. Regardless, capital spending by the energy industry accounted for 33 percent of all capital spending, and American states where hydraulic fracturing, or “fracking,” is prevalent have accounted for the bulk of job growth in the nation.

 

 

 

Frackers Now Pinched

Production has continued to increase on a combination of factors, including rising efficiencies and cost reductions. But currently, many U.S. frackers are pumping at a loss because they have debts to the tune of about $200 billion in total debt. 

 

As it is impossible for U.S. frackers to refinance those debts while bleeding cash, the most leveraged of the companies are probably heading toward insolvency. At the same time, the more successful ones won’t be able to take them over because they will have neither the cash nor the investor confidence that would help them secure debt financing.

 

The insolvencies and lack of expansion will result in output cuts in North America, but the Saudis and the United Arab Emirates will be expected to just keep pumping. After all, don’t forget that these are countries, not businesses, and oil is their lifeblood. The takeaway is this: A wave of business bankruptcies in the U.S. shale industry realigns global production.

 

Is U.S. Expansion Threatened?  

Lower oil prices remain a net benefit to oil-consuming coun­tries like the U.S., but they are definitely a strain on net oil exporters. Lower prices make more money available for domestic consumption rather than sending it abroad and reducing the overall cost of goods.

 

But for the U.S., this overall beneficial macroeconomic effect is smaller than it was a decade ago because net imports of foreign oil have fallen.

 

For the world as a whole, the boost to demand from cheaper oil should outweigh the negatives.

 

The world economy continues to grow, albeit at an uneven pace. Lower oil prices will drag inflation below zero in many advanced economies. For the U.S., where the economy is stronger, a temporary period of deflation should boost household spending and, therefore, growth.

 

But for southern eurozone countries, persistent deflation will make it even harder to achieve a sustainable recovery.

 

The Impact Of Energy On The S&P 500 Since 1980

 

ETFs To Stay With

Some of the best years for the S&P 500 have come when energy stocks have actually underperformed. Two factors have contributed to this.

 

Energy is no longer as meaningful a part of the overall index—its sector weight has dropped by close to half from its 2007 peak and it now only represents about 8.4 percent of the S&P 500.

 

That makes it sixth out of the 10 sectors and, the energy sector’s contribution to S&P 500 earnings per share contribution in the S&P 500 has collapsed due to declining margin contribution, even as the total EPS of the S&P 500 has risen to record levels.

 

S&P 500 Energy Sector Weight Dec. 31, 2014: 8.4%

S&P 500 SPDR ETF (SPY | A-98)

Vanguard S&P 500 ETF (VOO | A-97)

 

 

S&P Mid-Cap 400 Energy Sector Weight Dec. 31, 2014: 4.1%   

S&P 400 Mid-Cap SPDR ETF (MDY | A-79)

Vanguard S&P Small-Cap 400 ETF (IVOO | A-79)

 

 

S&P Small Cap 600 Energy Sector Weight Dec. 31, 2014: 3.5%

iShares Core S&P Small Cap ETF  (IJR A-92)

Vanguard S&P Small-Cap 600 ETF (VIOO | A-86)

 

 

At the time this article was written, the author’s firm owned shares of SPY, MDY and IJR on behalf of some clients.


 
Deborah Frame is vice president of investments and chief compliance officer at Cougar. She leads the research team there, including macroeconomic, market environment and asset class
correlation research used in the firm’s qualitative and quantitative asset allocation models that focus on downside risk optimization and the use of ETFs.
 
Cougar Global Investments, founded by Dr. James Breech, is a Toronto-based global tactical ETF portfolio strategist that uses only ETFs in its top-down global asset allocating strategies. Breech launched Cougar in 1993 around a downside risk management system he created. Contact Cougar Global at 800-387-3779 or [email protected].
 
 

 

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